In recent weeks, financial markets have undergone significant volatility and disruption in the wake of the COVID-19 pandemic, and the accompanying restrictions on a range of economic activities that have been imposed by governments across the globe.
As with the 2008 financial crisis, the market stresses accompanying the COVID-19 pandemic are likely to put the default, early-termination, and close-out provisions of bilateral derivative agreements to the test.
Below, we discuss some litigation risks relating to notice and valuation issues accompanying events of default and close-outs, some practical tips for managing the risk of litigation, and the potential applicability of force majeure and other defenses in light of the circumstances created by the COVID-19 pandemic.
We have also included an appendix containing the practical tips that can easily be forwarded to business teams.
Notice and Timing Requirements
For parties operating under the ISDA Master Agreements, events of default and termination events generally give rise to the right to terminate the agreement (or certain transactions thereunder) only after notice of the event has been delivered to the non‑defaulting party.
Derivatives contracts may allow multiple methods of delivery for certain notices, but typically require others (such as termination notices) to be delivered in person, by courier, or by mail, and are usually effective upon receipt.
Under such circumstances:
- contractual parties may allege that counterparties failed to comply with the notice provisions in the relevant agreements, thereby depriving them of the ability to mitigate their damages;
- in the bankruptcy context, a contractual party (through its trustee in bankruptcy) may allege that a counterparty failed to close out concurrently with the termination of the agreements as required by section 562 of the Bankruptcy Code. This may be particularly important where the close-out is delayed and prices decline further during that delay; and
- parties in bankruptcy may also argue waiver of the termination right if the counterparty does not promptly seek termination after default. Pursuant to the Southern District of New York Bankruptcy Court’s 2009 Metavante ruling, a non‑defaulting party wishing to terminate a master agreement with a bankrupt counterparty waives its early termination right if it does not seek termination “promptly” after the default.[1]
Parties should keep the following points in mind:
- In certain scenarios, it may not be in a contractual party’s interest to close out an agreement, even where an event of default has occurred (such as where the party would owe money after netting).
- Parties should be sure to comply with any applicable grace periods and consult all the underlying documentation (not just the master agreement) in order to determine the grace period that applies. Parties should pay particular attention to how government actions and unscheduled holidays may impact the calculation of such grace periods.
- Notices should be issued promptly and without delay, and parties should check the notice provisions in the underlying documents. If there are different notice provisions across different documents, it is better to be over-inclusive and comply with all of them.
- In cases where a particular delivery method is not possible (e.g. delivery in person), all attempts at delivery should be documented (e.g. including through photo and video evidence), and affidavits of service should be secured that attest to the impossibility of serving documents in the prescribed method.
- In addition, if service cannot be made via the prescribed methods (despite attempts to do so), efforts should be made (and documented) to employ alternative methods of providing actual notice—including by email or regular mail—even if these are not included within the prescribed methods of service. These efforts should be in addition to, and not in lieu of, attempting service via the prescribed methods.
Valuation and Close-Out
A number of issues may also arise in connection with the valuation and close-out of collateral. For example:
- Depending on the version of your ISDA agreement (1992 or 2002), the close out requirements for dealers and hedge fund counterparties may differ. To the extent that the parties affairs are governed by the 2002 version of the ISDA Master Agreement:
- Dealers may be able to rely on their internal models to determine the appropriate settlement amount, but must take care that their models are commercially reasonable and defensible in litigation.
- By contrast, hedge funds may need to obtain market quotes to calculate the close out amount and should take care to obtain those quotes from reasonable counterparties.
- For dealers, questions as to whether the close-out valuation was commercially reasonable are especially likely to arise where the underlying agreement allows one or both of (a) exposure under the transactions and (b) dealer discretion in valuing the asset (at least where prices are not readily available on a recognized market).
- Contractual parties may also claim that counterparties failed to conduct the process of obtaining quotations/bids in a manner that can be defended as no less favorable than would be the case if the counterparty were obtaining quotations/bids for itself. For example, parties may allege that close-outs were conducted without providing adequate time or opportunity for bidders to participate or for market makers to properly obtain and analyze information relevant to arriving at fair bids.
- If netting against a cash amount due and payable to a party is carried out by a counterparty before the collateral is reduced to cash, parties may also claim that netting was conducted improperly.
- Parties may also allege improper disclosure of information about the party to a bidder, resulting in them having the opportunity to front-run the close out.
In order to mitigate the risks of litigation, parties should keep the following points in mind:
- The close-out provisions of the applicable contract(s) should be followed as closely as possible, including permissible pricing sources and the method for arriving at a valuation.
- Market closures could impact the ability of parties to assign a value to the collateral. In such cases, the parties’ agreements may provide for waiting periods or other fallbacks, including alternate pricing methods and/or sources.
- Keep a detailed record of the steps taken during the close-out process including, but not limited to, the process for valuing the collateral, which institutions were asked to bid or quote, the timeframe for responses, information provided to them (and/or any other correspondence with them), and any other relevant aspects of the process.
Force Majeure and Other Defenses
The prevalence of market disruptions and government-mandated shutdowns accompanying the COVID-19 pandemic has also raised questions regarding the potential applicability of the force majeure and illegality provisions of derivatives agreements.
Under the 2002 ISDA Master Agreement,[2] when a force majeure or illegality event is triggered, payment and delivery obligations are deferred for a waiting period (eight business days for force majeure, three for illegality), after which either party may elect to terminate some or all of the affected transactions.
Although these provisions should be kept in mind by the parties to derivatives agreements, it is worth noting that they are narrowly tailored and apply only in limited circumstances:
- Force majeure will only apply where payments or deliveries become impossible or impracticable. Thus, for example, it will likely not apply to cash-settled transactions where payment systems remain operational (even if the physical market is subject to disruption).
- Similarly, the illegality provisions of the ISDA Master will only apply where it becomes unlawful under applicable law for a party to make or receive payments or deliveries required under the agreement.
Parties should keep the following points in mind:
- The exact provisions of the force majeure, illegality, and other potentially applicable provisions should be consulted to determine what options are available.
- Under the 2002 ISDA Master Agreement, parties becoming aware of force majeure or illegality events are required to promptly notify the other party of the existence of the event.
- Consult with counsel regarding the potential applicability of other common law defenses, such as the "frustration of purpose" doctrine under New York law.
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As the coronavirus pandemic continues to have an increasing impact on markets on a global level, and for an indeterminate period of time, the market repercussions will continue.
While these exact circumstances may be unique, the notice and valuation disputes that are likely to follow are similar to those that have been litigated before, and we remain available to help guide you through decision-making that can help minimize the risk of future litigation.
[1] In re Lehman Bros. Holdings Inc., 2009 WL 6057286 (Bankr. S.D.N.Y. Sept. 17, 2009).
[2] Although the 1992 ISDA Master Agreement does not contain a force majeure provision, the user’s guide to the 1992 Master contains an impossibility provision which is similar to force majeure and may be incorporated into the agreement by the parties.
The authors would like to thank the following for their contribution to this post:
